Goodyear (ticker: GT) is one of the largest stock holdings of celebrated hedge-fund manager David Tepper's high-performing Appaloosa fund, with a 4.5% position. And just last month, Marcato Capital Management bought a 4.25% stake of 10.5 million shares. Richard "Mick" McGuire, Marcato's founder, shared with Barron's his thesis for his substantial commitment of about $270 million for a fund with under $3 billion in assets. He's looking for a better than 50% jump in the stock over the next two years, from about $26 to over $40, based on earnings growth for the next three years that Goodyear projects at 10% to 15%, compounded annually, on sales increases of 2% to 3% per year.

For one thing, auto production is snapping back in Goodyear's two biggest markets: North America, which accounts for 42% of company revenue, and Europe, the Middle East, and Africa, which chip in 38%. And, of course, tire-sale revenue will also be bolstered by expanding auto fleets in the developing world, particularly Asia, where Goodyear gets 11% of its revenue. Although growing less rapidly, Latin America kicks in 10% of revenue.

Takeoff: The U.S. and Europe are revving up, and China could surge.
Photo: CSM/Landov

In 2009, North American light-truck and car volume bottomed out at about 10 million units; it's now tracking close to 16 million units on a seasonally adjusted annual rate. After six years of decline, European light-truck and car volume is expected to rise 3% to 14 million in 2014, according to Deutsche Bank. In China, sales should gain 10% to 23.8 million, says the bank.

Of course, original-equipment makers drive hard bargains with tire companies that want to showcase their wares on new cars and trucks. But, says McGuire, the tire makers cash in on the sale of replacement HVA tires, where margins are fatter. Replacement sales account for about 70% of Goodyear's unit sales.

And the tire-replacement market figures to be strong over the next few years, claims McGuire. The replacement cycle heats up about three years after the purchase of a new car, when the vehicle has traveled roughly 30,000 to 40,000 miles. Motorists tend to stick with HVA products on that first tire change because the higher price is more than compensated for over nonbrand tires by superior mileage, less noise, and better grip on wet roads.

"And we see a big surge coming in replacement sales for Goodyear, due to the jump in U.S. new-auto sales since the Great Recession, along with a rise in annual miles driven," avers McGuire.

CHINA ALSO OFFERS VAST potential, particularly for replacement business, says McGuire. In the U.S. and Europe, the replacement market is three to four times the size of the original-equipment one. Because the car market is so much newer in China, the replacement market is about 1.3 times the new-car tire market. Any expansion would be great for Goodyear and its two main rivals, McGuire says.

Beyond the growing demand for replacement tires, Goodyear has other positives, says McGuire. In restructuring over the past five years, it not only improved its product mix, but also renegotiated labor contracts and closed unproductive facilities, like one in Amiens, France.

Goodyear CFO Laura Thompson, in a May 29 conference call with analysts, said the company could make its 10%-to-15% earnings-growth objective in each of the next three years by selling three million to five million more tires a year and continuing its cost-cutting.

Another positive for Goodyear was prefunding some $1.15 billion of its unfunded pension-fund obligations this year, drawing mostly from working-capital reserves. Its unfunded pension liabilities—$3.5 billion two years ago—are a more manageable $700 million. The reduction will be accretive to earnings.

The Bottom Line

Shares of the rubber giant could gain more than 50%, to $40, within two years as more cars need a tire change as they near 40,000 miles.

Lastly, the stock is dirt cheap, based on the tire maker's expected earnings power over the next three years. McGuire estimates that 2016 earnings before interest, taxes, depreciation, amortization, and pension (Ebitdap) contributions will clock in at $2.69 billion. Ebitdap is certainly a mouthful, but at six times the company's total enterprise value (which captures net debt, stock-market capitalization, minority interests in its European operation, projected free-cash flow for most of 2014 and all of 2015, and unfunded pensions) would imply a share price of $38.50. At a still-reasonable 6.5 times enterprise value, Goodyear's Ebitdap would mean $43.25 a share.

McGuire is similarly looking for Goodyear's 2016 GAAP earnings before special charges to be about $4.12 a share. Using Goodyear's historic average price/earnings ratio of 10, that would produce a stock price of $40 or more by his reckoning. And the company recently initiated a quarterly dividend of five cents a share.

Clearly, Goodyear shares are underinflated. Low tire pressure can be a hazard to drivers. But, in this case, it offers investors the prospect of a smooth ride.